Depreciation And Income Taxes

CHAPTER 7

Depreciation

Decrease in value of physical properties with passage of time and use.

More specifically:

Accounting concept establishing annual deduction against before-tax income to reflect effect of time and use on asset’s value in firm’s financial statements

to match yearly fraction of value used by asset in production of income over asset’s economic life

Property Is Depreciable if it Meets These Requirements :

be used in business or held to produce income.have a determinable useful life which is longer

than one yearwear out, decay, get used up, become obsolete,

or lose value from natural causesnot be inventory, stock in trade, or investment

property

Depreciable Property (Tangible , Intangible )

Tangible : can be seen or touched

personal property( المنقولة includes : (االموالassets such as machinery, vehicles, equipment, furniture, etc...

real property( المنقولة غير anything : (االموالerected on, growing on, or attached to land(Since land does not have a determinable life itself, it is not depreciable)

Intangible : personal property, such as copyright, patent( االختراع )or franchise (براءات معين ,امتياز إعفاء )

When Depreciation Starts And StopsDepreciation starts when property is placed in service for

use in business or for production of income.Property is considered in service when ready and available

for specific use, even if not actually used yet.Depreciation stops when cost of placing it in service has

been recovered or when it is soled, whichever occurs first.

Additional Definitions

Basis, or cost basis : (unadjusted cost ) initial cost of purchase an asset, plus sales tax, transportation, and normal costs of making asset serviceable

Adjusted cost basis : allowable adjustment (increase or decrease) to original cost basis, used to calculate depreciation deductions

Improvement of the asset increases the original cost basis

Casualty or theft loss decrease the original cost basis

Basis, or cost basis : (unadjusted cost ) initial cost of purchase an asset, plus sales tax, transportation, and normal costs of making asset serviceable

Adjusted cost basis : allowable adjustment (increase or decrease) to original cost basis, used to calculate depreciation deductions

Improvement of the asset increases the original cost basis

Casualty or theft loss decrease the original cost basis

Additional Definitions

Book Value (BV) : Worth of depreciable property as shown on company records

Represents amount of capital remaining invested in property and must be recovered in future through accounting process

(Book Value)k= k

adjusted cost basis - Σ (depreciation deduction)j

j=1

Book Value (BV) : Worth of depreciable property as shown on company records

Represents amount of capital remaining invested in property and must be recovered in future through accounting process

(Book Value)k= k

adjusted cost basis - Σ (depreciation deduction)j

j=1

Additional Definitions

Market Value (MV) : Amount paid by willing buyer to willing seller for property where no advantage and no compulsion to transact

approximates present value of what will be received through ownership of property, including time-value of money (or profit)

Market Value (MV) : Amount paid by willing buyer to willing seller for property where no advantage and no compulsion to transact

approximates present value of what will be received through ownership of property, including time-value of money (or profit)

Additional Definitions Recovery Period :Number of years over which

basis of property is recovered through accounting process.

Normally the useful life for classical methodsProperty class for General Depreciation

System (GDS) under MACRSClass Life for Alternative Depreciation

System (ADS)Recovery Rate :Percentage for each year of

MACRS recovery period used to calculate an annual depreciation deduction.

Recovery Period :Number of years over which basis of property is recovered through accounting process.

Normally the useful life for classical methodsProperty class for General Depreciation

System (GDS) under MACRSClass Life for Alternative Depreciation

System (ADS)Recovery Rate :Percentage for each year of

MACRS recovery period used to calculate an annual depreciation deduction.

Additional Definitions Salvage Value (SV) : Estimated value of

property at the end of useful life. expected selling price of property when asset

can no longer be used productivelynet salvage value used when expenses incurred

in disposing of property; cash outflows must be deducted from cash inflows for final net salvage value

with classical methods of depreciation, estimated salvage value is established and used

with MACRS, the salvage value of depreciable property is defined to be zero

Salvage Value (SV) : Estimated value of property at the end of useful life.

expected selling price of property when asset can no longer be used productively

net salvage value used when expenses incurred in disposing of property; cash outflows must be deducted from cash inflows for final net salvage value

with classical methods of depreciation, estimated salvage value is established and used

with MACRS, the salvage value of depreciable property is defined to be zero

Additional Definitions

Useful Life : Expected (estimated) period of time property will be used in trade or business or to produce income; sometimes referred to as depreciable life.

Useful Life : Expected (estimated) period of time property will be used in trade or business or to produce income; sometimes referred to as depreciable life.

The Classical Depreciation Methods

N = depreciable life of the asset in yearsB = cost basis, including allowable adjustmentsd k = annual depreciation deduction in year k (1< k <N)

d k* = cumulative depreciation through year k

BV k = book value at the end of year k

BV N = book value at the end of the depreciable (useful) life

SV N = salvage value at the end of year N

R = the ratio of depreciation in any one year to the BV at the beginning of the year

Straight-Line (SL) MethodSimplest depreciation methodAssumes constant amount is depreciated each year

over depreciable (useful) life

N = depreciable lifeB = cost basisdk = depreciaton in k

BVk = book value at end of k

SVN = salvage value

Declining Balance (DB) MethodSometimes called constant percentage method or Matheson formulaAssumed annual cost of depreciation is fixed percentage of BV at

beginning of yearR is constant R = 2 / N when 200% declining balance OR R = 1.5 / N

when 150% declining balance used

d 1 = B ( R )

d k = B ( 1 - R ) k - 1 ( R )

d k* = B [ 1 - (1 - R ) k ]

BV k = B ( 1 - R ) k

BV N = B ( 1 - R ) N

Because declining balance method never reaches BV = 0, it’s permissible to switch from this to straight-line method so asset’s SVN will be zero or other desired value

Units-of-Production MethodNot based on the idea that decrease in value of

property is a function of timeDecrease in value is mostly a function of useMethod results in cost basis (minus final SV)

being allocated equally over the estimated number of units produced during useful life of asset.

Depreciation per unit of

production =

DB with Switchover to SLDB method will NEVER reach BV =0 You can switch from DB to SL The switch over occurs in the year in which

a larger depreciation amount is obtained from SL method

Table 7-1 page 328d k = ( B - SVN ) / N

But the basis B from Col(1)Changed every year and N is the remaining years As followes :

Year (3)

1 4,000/10 years =400

2 3,200/9 year = 355.65

3 2,560/8years = 320

And so on

We select the largest depreciation amount .

ثــالثة cمe الظgل : iهk الل cولcرس قال قال cهe عن الله رضiي qكi مال iنe ب iأنس eعن

ثالثة : " : cمe الظgل وسلم عليه الله هc صلى cرiفeيغ ال eم cل فظcهk هc ، الل cرiفeيغ eم cل cهc ، وظ ك cرe يت ال eم cل ال وظ kذiي ال cمe الظgل فأمkا ،

cهk الل cه cرiفeيغcك eر eم , : } فالش� cل لظ ك eر الش� kنi إ cهk الل قال } ، cه cرiفeيغ kذiي ال cمe الظgل وأمkا eفcسهcمe عظiيم أن iبادiالع cمe cل فظ

eمiه� رب eن وبي eمcنهe بي ال- - فiيما kذiي ال cمe الظgل وأمkا ، وجل عز ، cهc ك cرe بعeض�ا يت eمcضهeعc ب iبادiالع cمe cل مiنe , فظ eمcضهeبع gصcيق kى حت

eجامiع "   : ال صحiيح انظر qضeيحة , : 3961بعiحk1927الص

Taxable Income(Before Taxable Income)

taxable income = gross income - all expenses - depreciation

The disposal of a depreciable asset can result in a gain or loss based on the sale price (market value) and the current book value

A gain is often referred to as depreciation recapture, and it is generally taxed as the same as ordinary income. A loss is a capital loss. An asset sold for more than it’s cost basis results in a capital gain.

After Tax Economic Analysis

Rk = revenues (and savings from the project: cash inflow from project during period ‘k’

Ek = cash outflows during year k for deductible expenses and interest

dk = depreciation

t = effective income tax rate on ordinary income (federal, state and other); assumed to remain constant during the study period

Tk= income taxes paid during year ‘k’

BTCFk = Before Tax Cash Flow for year k

ATCFk = After Tax Cash Flow for year k

The taxable income = ( Rk – Ek- dk )

The income tax: Tk = - t ( Rk – Ek – dk )

BTCFk = Rk – Ek

ATCFk = BTCFk + Tk

= (Rk – Ek ) - t ( Rk – Ek – dk )

= (1 – t)(Rk – Ek ) + t dk

Example:

An asset is expected to produce a net cash inflows of 70,000 per year for the six year period , where the cost basis is 260,000 and the market value is 20,000. MARR is 10% use SL method …..

A) develop BTCFB)develop ATCF C) Calculate the PW for both CFs

BTCF0 -260,000

1 70,000

2 70,000

3 70,000

4 70,000

5 70,000

6 70,000

6 20,000

PW= -260,000 + 70,000 (P/A,10%,6)+ 20,000(P/F,10%,6) = -260,000 +70,000(4.3553) +20,000 (0.5645)=56,161PW >0 it is acceptable alternative

SL = (260,000 -20,000)/6 =40,000 per year

ATCFEOY A

BTCF BDepreciation Deduction

C=A – B Taxable Income

D= - 0.4CIncome Tax

E= A+D ATCF

0 -260,000 -260,000

1 70,000 40,000 30,000 -12,000 58,000

2 70,000 40,000 30,000 -12,000 58,000

3 70,000 40,000 30,000 -12,000 58,000

4 70,000 40,000 30,000 -12,000 58,000

5 70,000 40,000 30,000 -12,000 58,000

6 70,000 40,000 30,000 -12,000 58,000

6(market value)

20,000 20,000PW= -260,000 + 58,000 (P/A,10%,6)+ 20,000(P/F,10%,6) = -260,000 +58,000(4.3553) +20,000 (0.5645)= 3,897.4PW >0 it is acceptable alternative